Failure of Eurozone policies will lead to full QE; positive for shares

Europe has given investors little to cheer about this year. After the soothing words about doing what it takes to support the Euro and EU, Eurozone problems seem to be getting worse in 2013. 12% average unemployment across the region – rising over the past year – calls current economic policy into question. Yet, the very scale of these problems, and the failure of EU policies to date, could prove to be good news for markets. Change must come.

The behavioural bias of representativeness often confuses investors into thinking that shares should in some way relate to the performance of the economy. Yet despite the long term linkage, wide divergence is possible in the short and medium term. Valuation, sentiment and changes in prospects can all separate the performance of shares and economies for long periods. Now, stockmarket prospects could be about to improve. Europe has yet to attempt unlimited quantitative easing, but the dire state of the Eurozone might now force unprecedented intervention. This year, the surprise could be that Europe goes down the US and UK route, boosting markets.

The stockmarket continually provides examples of this divergence. Stocks may look like they should have something to do with their underlying economic exposure, but the economic outlook and individual business characteristics matter more. For example, the gold price has more than doubled over the past seven years, but gold shares on average are unchanged. The representativeness bias leads investors to think of a share in a gold producer as a leveraged play on the underlying commodity. But rising costs of extraction and other adverse factors conspire to break the relationship. Similarly, investing in Europe’s broken economies and banking system looks foolhardy, but a bail out could be in prospect.

The UK has stolen a march on Europe, by applying loose monetary policy and QE. UK QE has been larger relative to GDP than in either the US or the Eurozone, and the weaker Pound that has resulted has helped exports. While the results of QE are debated, Europe has little else to try. At the very least it could bring the Euro down to a more competitive level, and could help banks extricate themselves from debt problems. The price of keeping the Euro could be that the currency itself is devalued. For politicians, it is an easy option. Even in Germany, support for the Euro is weakening, and printing money is usually less contentious than tax hikes, spending cuts and austerity. Europe might even be able to apply QE with better targeting than the UK, in terms of assets purchased. Europe’s focus should be on economic stimulation, not bailing out bad debt.

Nevertheless, it is likely that liquidity will flow into shares and hard assets like prime property. A weaker Euro would also help German industrial exports, which are at risk from the slowdown in Eastern Europe and China. Were it not for Germany’s history and strong stance against debasing currency, the markets might have attached greater probability to this outcome. But ultimately politicians will be pragmatic. Unemployment threatens re-election prospects for current governments around Europe, and possibly even challenges democracy itself in some countries. For Germany, the prize of keeping the Eurozone together will mean some principles are sacrificed.

Investors should recognise that Europe’s problems will trigger radical action. Policies must change, and shares should benefit. Although economic data is weak, investors should pay more attention to politics and the language used by European leaders. The Eurozone is challenged, but has not yet run out of options.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. Data and content provided are for information, education, and non-commercial purposes only. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice.

No comments yet... Be the first to leave a reply!

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: